Zale-Analyst’s Enthusiasm Misplaced.

Implications: As Zale increases its Fy09 earnings guidance, it is apparent management is promising the least likely numbers rather than the most probable ones.  Here is why investors should be concerned.

Analysis: Zale reported 4th quarter sales and year end results for fiscal year 2008 ending July 31st.  Not surprisingly the company lost money in the fourth quarter, but less than expected.  According to statements released, Zale lost ($4.9) million this quarter versus a gain of $0.7 million for the last quarter of FY07.  Actually, the company did quite a bit better if you ignore one time benefits and charges to the P & L.  Operationally, Zale lost only ($0.7) million this year without the one time cost of a vacation accrual and the benefit of the sale of an asset.  That compares favorably to last year’s loss of ($7.1) million if the gains from derivatives and a Canadian investment tax credit were factored out of the P & L.  However, for fiscal year 2008, the company’s annual earnings declined about 92%which was primarily due to weak Christmas quarter sales and lower margins as a consequence of the company’s liquidation of about $129 million of inventory during the second half.  For Fy08 earnings were $3.7 million versus $48.1 million for the previous year.  

Regardless, Zale’s stock price closed considerable higher on the news, propelled in small part by better than expected quarterly results, but more so because of Zale management not only confirmed analysts earlier earnings estimates for Fy2009, but increased them.  Management now expects Fy09 earnings will be between $1.10 and $1.25 per share on a fully diluted basis.  Earlier, analysts had expected Fy09 earnings to be about $0.90 per share.   

I think that revision came as a ‘big’ surprise to many traders which pushed the stock’s price well above it previous 52 week high to $27.80 on heavy volume.  That was good news for a number of shareholders who quickly took the opportunity to unload more than 4.5 million shares on August 28th and another 1.1 million shares on the 29th.  The fact is Zale’s stock has had a volatile trading record over the last 30 days.  For example, Artisan Partners quietly liquidated their entire 4.7 million share holding.  In total, about 59% of Zale’s funds have been selling stock.  That’s in contrast to 27.2% buying Zale shares.  Clearly, many investors were skeptical about Zale’s 2009 prospects and it’s not clear why these results should have changed that.  

According to CEO Goldberg, the company’s new earnings projections will be achieved with flat sales (flat to down 1%); lower expenses, higher margins, and improved assortments.  However despite his bravado, some of the numbers just don’t add up.  For instance, Fy08 SG&A costs were actually higher than in Fy07 despite the company’s plan to significantly reduce expenses.  Granted, 4th quarter SG & A declined about $2.2 million, but 3rd quarter’s expenses was actually about $9 million higher.  It isn’t clear that investors can depend on management to deliver a material reduction in operating costs to drive earnings.  Inventory levels should also concern investors.  

As of year end, Zale’s inventory at cost was $779.6 million which was a $241.6 million reduction from the previous year.  That decline was a decrease of about $112 million from the sale of Bailey Banks, and Biddle and according to the company, the permanent clearance of $129 million in inventory during the second half of Fy08.  Assuming a flat sales plan, Zale buyers will be placing orders for about 15% less merchandise at cost to support 4th quarter sales.  The decline in units is even more severe when gold and diamond price increases are factored into the open to buy. Realistically, that doesn’t leave much open to buy to support the introduction new product this fall to drive full price sales and its new product sold at full margin that will be instrumental in the company achieving its aggressive new earnings projections.  Sadly for Zale’s newest shareholders, management mistakenly believes that two year old styles that have been marked up several times and possibly advertised at lower prices in previous quarters will be sufficient to sustain higher margins.  But they won’t if history is any measure, and then there are management’s sales expectations.  

The company achieved about a 6.2 % sales increase in Q3 and 6.0% in Q4.  That’s in contrast to 5%-6% declines for many if its large competitors.  Those sales increases were driven in most part by up to 70% off clearance sales which depressed gross margins to about 47.5% in the second half.  It’s reasonable to think Zale’s performance would have been at best equal to and probably worse than its competitor’s sales without the drastic cut in gross margins. That means its second half sales could have declined between 5% and 10% if the company had maintained historic margin rates.   

Despite this, management expects the company can achieve flat sales at historic margin rates for Fy09  That’s a real leap of faith which is even more incredulous when you consider what it means on a quarter by quarter basis.  Effectively it implies that Christmas quarter’s sales will have to substantially increase to achieve flat annual sales.  That’s because 2nd half sales are likely to be down mid to high single digits as the company comes up against last years liquidation sales.  The company may counter that it will have better assortments in the second half, but with little open to buy for new product for fall 08, Zale will have what’s left over after Christmas which is a lot less than less year, a year older, and higher priced too.

In addition, there are a host of ‘soft’ factors that will make achieving management’s new earning projections even more problematic.  These include a management team that is still changing, historic execution problems which haven’t been corrected, continued staff attrition at the store level, and most importantly, management’s inexperience.  In a business that counts retail skill and seniority in terms of the number of Christmases not sales quarters, five of eight of Zale’s executive managers has never planned or operated a bricks and mortar jewelry business through a Christmas quarter.  That includes the company’s current CEO, President, Chief Stores Officer, and Chief Merchandising Officer.  That’s really scary.  

Still, on Tuesday, September 2nd, Zale’s stock price reached a new 52 week high of $29.19, while about 44% of Zale’s stock float remained short sold.  Whether the number of shares sold short will increase in the coming weeks isn’t clear, but with Zale’s stock selling at 93% of its 52 week high, management’s inexperience and a fragile sales plan, more investors may wish they had hedged their bet.

After four years of disappointments and with big stock buy backs maxed out, the board has just about run out of wiggle room to turn this company around.  Unfortunately, their numbers don't really add up this time either.  So despite investor's recent enthusiasm, Zale's performance is likely to be left to a quirk of fate or a prayer that a strengthening economy saves the Christmas quarter for this embattled diamond jeweler.